ARA Analysis - Part IV

Part IV

Office Market Analysis

I have done a market analysis of the office market in Singapore. As this research was a joint effort with a friend, I feel it is not appropriate to mention the details of our conclusions. But let me just note a few general points that will be crucial for the discussion below.

i) vacancy rates having reached a level where the odds of it reaching a peak soon is high. A peaking in the vacancy rates will translate to a bottoming in capital values.

ii) bottoming in capital values has consistently been preceded by a leading indicator which has since convincingly shown a positive signal.

iii) cap rates has been a much more significant driver of capital values than rental rates, which lag capital values

iv) supply has surprisingly shown little impact on the movements in capital values

From these few points, we believe that capital values for the office market should bottom some time in mid-2010 despite talks about a huge supply of office space coming online (which really is small relative to the total office space available)

Rentals rates should continue its downward movement with a bottoming expected only in 2011.

The conclusions from this analysis will support the conclusions drawn below on several areas which we earlier said (in Part III) more work needs to be done:

Rental Rate Risk

As agreed, rental rates reversion is likely - the question is how much. Rental rates specific to ARA-managed assets were not available. But basing off general market data for Singapore (from URA), we see that rents for offices in the central region peaked in 2Q2008 and have since dropped 27% from the the peak. Rental rates are still dropping but at a slowing rate on a q-o-q basis. We can expect rental rates to keep dropping before reaching a bottom some time in mid-2011.

Even though rental rates have been dropping in 2Q2008, the effect of the drop should only be more apparent in 2010 (i.e. it lags). This is because rental contracts in the office market is done on a 3-year lease. So the average rental rates receieved by the landlord is effectively an average of the rental rates for the past 3 years - a 3-year rolling rent. As a result of this, the average rental rate receivable by a landlord has still been somewhat sheltered from the drop in rental rates as old leases (yr 2007) based off the high rental rate have helped hold the average rental rate up. However, as the 2007 leases expire, we should see the average rent receivable drop much more on a y-o-y basis. The only saving grace is that it is on a rolling basis. So on a q-o-q basis, the fall in NPI will accelerate but it still going to be gradual (a few % pts) and not drastic.

Once again, because its on a rolling basis, the % change in rental rates received by a landlord will be much less than what you see in the papers - the rolling leases help to smooth up the changes in rental rates. Hence, it will fall less on the downside and correspondingly, gain less on the upside.

On a y-o-y basis, we expect the rent receivable by a landlord in 2011 to fall by 10%. This means that ARA's peformance fee should drop by a corresponding 10% as the performance fee is a based off a % of NPI, which moves in tandem as rental revenues ( linear change or disproportionate?)

Capital Value Risk

We note that ARA has done recent revalutions for Fortune REIT and Prosperity REIT in 2H09 and the revaluations were upwards. ARA has yet to do a revaluation for Suntec REIT. As a REIT manager where fees are paid when valuations increases, ARA has all the reasons to do a valuation when they expect it to increase. Hence, the fact that ARA has yet to do one for Suntec REIT implies that the revaluations will likely be downwards. Suntec REIT will have to do a revaluation for its Y/E accounts.

But the % drop is hard to estimate, though the recent fund raising by Suntec REIT could give us a sign. The fund raising help reduced gearing by 3% pts. If the amount raised was to prepare Suntec REIT for a rise in gearing as asset values dropped and the amount raised was just enough such that when revaluations hit, the gearing will be back at the original level , then we can expect ~10% drop in valuation.

Mathematical proof: debt/asset = 34/100 = 34%. Gearing drop to 31%, meaning assets increased to 110. To move back to 34%, asset must drop back to 100 - i.e. drop by 10. 10/100 where 100 is the value of the assets, is a fall of 10%.

The effect for ARA is mixed because some of the funds (Prosperity and Fortune) have experienced a revaluation upwards while Suntec REIT should experience a devaluation.

But as mentioned above, we expect capital values to bottom in mid 2010. And if that happen, then ARA will quickly revalue Suntec REIT and this will swiftly mitigate whatever drop in valuations expected to come through at the start of the year.

In conclusion, base rate receivable for ARA in 2010 should drop by 5 to 10% on a y-o-y basis.

Ability to Raise Funds - Performance of ADF

As mentioned, we might also need to assess the probability of success for ARA's flagship Asian Dragon Fund (ADF). Given the lack of transparency on the private funds, we have to do some guesswork here.

ADF has a 4 year investment period. Because of the restriction that ARA can't raise similar fund as long as invested amount is <75%>

In conclusion, the ADF fund should do decently well. In 2011, we might see ARA's financial results being bumped up as the fund exits and ARA book some carried interest and profit from the asset sale. We should also expect ARA to raise new private funds in late 2010/2011 as >75% of ADF gets invested.

~ To Be Continued ~